3.3 Lease classification criteria

Lease classification is governed by five criteria. Although the guidance considers whether a lease is economically similar to the purchase of a nonfinancial asset from the perspective of control, the classification approach is substantially similar to previous guidance. If any of the five criteria in ASC 842-10-25-2 are met, a lessee should classify the lease as a finance lease and the lessor would classify the lease as a sales-type lease. If none of the criteria are met, a lessor would classify a lease as a direct financing lease if the criteria in ASC 842-10-25-3b are met. All other leases should be classified as an operating lease by both the lessee and lessor.

Although lessors are generally subject to the same classification criteria as lessees, additional considerations relevant to any revenue generating activity – such as the collectibility of amounts due under the lease – may impact the timing and recognition of selling profit or loss, or income over the lease term. Furthermore, under the lease classification criteria, lease arrangements with variable lease payments may be classified by lessors as a sales-type or direct-financing lease. This may lead to the recognition of a selling loss (i.e., a day-one loss) by the lessor even when the overall arrangement is expected to be profitable. In response to concerns raised in the post implementation review, in order to avoid recognition of such day-one loss under ASC 842, the FASB issued ASU 2021-05 which upon adoption requires a lessor to classify a lease with variable lease payments (that do not depend on an index or a rate) as an operating lease at the lease commencement date if classifying the lease as a sales-type lease or direct financing lease would result in recognition of a day-one loss. See LG 9.10 for the effective date and transition requirements of ASU 2021-05. See Example LG 4-9 for an illustration of a lease with significant variable payments.

A reporting entity that elects the exception for short-term leases would not apply the lease classification criteria. See LG 2.2.1 for information on the short-term lease measurement and recognition exemption.

Figure LG 3-3 provides the lease classification criteria contained in ASC 842-10-25-2 and ASC 842-10-25-3.

Generally, yes. The lessee and the lessor apply the same basic classification criteria; however, differences in assumptions used to classify the lease (e.g., discount rate and the impact of renewal or purchase options) could give rise to classification differences. Lessor classification may also be impacted by factors unrelated to the lessee. For example, a lessor may obtain residual value insurance from a third party and include that guarantee in its lease payments. This could result in the lessor classifying the lease as a direct financing lease while the lessee classifies it as operating.

Furthermore, under the lease classification criteria, lease arrangements with variable lease payments may be classified by lessors as a sales-type or direct-financing lease. This may lead to the recognition of a selling loss (i.e., a day-one loss) by the lessor even when the overall arrangement is expected to be profitable. In response to concerns raised in the post implementation review, in order to avoid recognition of such day-one loss under ASC 842, the FASB issued ASU 2021-05 which upon adoption requires a lessor to classify a lease with variable lease payments (that do not depend on an index or a rate) as an operating lease at the lease commencement date if classifying the lease as a sales-type lease or direct financing lease would result in recognition of a day-one loss. See LG 9.10 for the effective date and transition requirements of ASU 2021-05. See Example LG 4-9 for an illustration of a lease with significant variable payments.

Question LG 3-3
Can the classification criteria be applied to a group of leased assets (i.e., a portfolio approach)?

Yes. However, the results must not be materially different than classifying the underlying assets on an asset by asset basis. As a result, this approach would likely only be permitted in situations where the lease applies to a group of homogenous assets that have identical or nearly identical lease terms.

Question LG 3-4
Do the lease classification criteria in ASC 842-10-25-2 and ASC 842-10-25-3 apply to leases of land?

Yes. Leases of land should be classified like any other lease; that is, evaluated based on the lease classification criteria in ASC 842-10-25-2 and ASC 842-10-25-3. Consequently, long-term leases of land may be classified as finance leases.

3.3.1 Transfer of ownership

A lease is classified as a finance lease by a lessee and as a sales-type lease by a lessor if ownership of the underlying asset transfers to the lessee by the end of the lease term. This criterion is also met if the lessee is required to pay a nominal fee for the legal transfer of ownership. However, if a lessee can choose not to pay the nominal fee (resulting in the lessee having the option not to purchase the underlying asset), the provision would not meet the transfer of ownership criterion because it would be considered an option to purchase the underlying asset. See LG 3.3.2 for information on the accounting for options to purchase the underlying asset.

It may be difficult to distinguish between a finance lease (subject to the guidance in ASC 842) and a financed purchase (sale) of an asset (subject to the guidance of ASC 606). Under ASC 606, the transfer of legal title to a buyer is an important indicator when determining whether an entity has transferred control of an asset to a customer, but that fact is not determinative in isolation. A question arises as to whether an arrangement should first be evaluated under ASC 606 or ASC 842. For example, since transfer of title does not automatically govern whether an entity has transferred control of an asset to a customer, it is not clear which standard should govern the accounting when title is not transferred to the customer at the beginning of the arrangement. Similarly, it is unclear which standard should govern when an arrangement does transfer legal title to the customer, but that transfer is not, in isolation, determinative as to whether a sale has occurred.

We believe that reporting entities should generally apply ASC 842, except when legal title transfers at the beginning of an arrangement. This may result in an entity classifying a lease as a sales-type (finance) lease, but, nevertheless, the transaction would be accounted for under ASC 842. Reporting entities should first apply the guidance in ASC 606 when legal title is transferred to the customer at the beginning of an arrangement. However, per ASC 606, an entity that transfers a good and retains a substantive forward repurchase obligations or call option (that is, a repurchase right) should not recognize revenue when the good is initially transferred to the customer because the repurchase right limits the customer’s ability to control the good. If the repurchase price is less than the original sales price of the asset and the arrangement is not part of a sale-leaseback transaction, the arrangement would be subject to the accounting and lease classification guidance under ASC 842.

3.3.2 Purchase options

If a lease contains an option to purchase the underlying asset and the option is reasonably certain to be exercised by the lessee, the lessee and lessor should classify the lease as a finance lease and a sales-type lease, respectively. An option may be reasonably certain to be exercised by the lessee when a significant economic incentive exists. For example, this may exist when the price of the option is favorable relative to the expected fair value of the underlying asset at the date the option becomes exercisable or when certain economic penalties exist that compel the lessee to elect to exercise its option. See LG 3.4 for additional information on the impact of economic factors on the application of the reasonably certain threshold.

3.3.2.1 Purchase option prices

A purchase option, whether fixed price or formula driven, should be evaluated to determine if it represents a significant economic incentive such that the lessee is reasonably certain to exercise it. Generally, an option to purchase a leased asset at a price greater than or equal to an asset’s fair value at lease commencement would not give rise to a significant economic incentive based on price. Additional consideration is required when a fixed-price option allows the lessee to buy the asset at a price that is less than the fair value of the asset at the lease commencement date. Both the lessee and lessor should consider all relevant factors, including the nature of the leased asset and the length of time before the option becomes exercisable, which may impact the likelihood that the lessee would exercise the option. For example, an option to purchase real estate at a price below the commencement date fair value is more likely to be considered reasonably certain of exercise than a similar option on equipment since real estate is generally expected to appreciate in value over the lease term whereas equipment is more likely to depreciate in value.

3.3.3 Lease term test

If the lease term is for a major part of the remaining economic life of the underlying asset, the lessee has effectively obtained control of the underlying asset and should classify the lease as a finance lease; the lessor should classify the lease as a sales-type lease. While ASC 842 does not require the use of bright lines, one approach to applying this indicator is to consider a lease term to be for a major part if it is equal to or greater than 75% of the underlying asset’s remaining economic life. As land has an indefinite life, this criterion would not apply to leases of land.

Leases that commence at or near the end of the underlying asset’s economic life are exempt from applying this particular lease classification criterion. When determining if a lease has commenced at or near the end of the underlying asset’s economic life, use to date and the remaining economic life of the underlying asset at lease commencement should be considered. The FASB has indicated that one reasonable approach to determining the applicability of this exception is to conclude that a lease that commences in the final 25% of an asset’s economic life is at or near the end of the underlying asset’s economic life. While there may be differing views in practice, we believe this exception should apply whenever entities are required to classify a lease, e.g., when a lease is modified and the modification is not accounted for as a separate lease. We believe that, for classification purposes, the “commencement date” for an existing lease that is modified is the date the modification is executed.

See LG 3.3.3.2 for additional information on determining the estimated economic life of a leased asset.

3.3.3.1 Determining the term of the lease

Leases often include options to either extend the term of the lease (commonly referred to as a “renewal option”) or to terminate the lease prior to the contractual lease expiration date (commonly referred to as a “termination option”).

As discussed in ASC 842-10-30-1, a lessee or lessor should consider all relevant contractual provisions, including renewal and termination options, to determine the term of the lease. Only renewal or termination options that are reasonably certain of exercise by the lessee should be included in the lease term. Additionally, if a renewal option is controlled by the lessor, the lessee and lessor must include that renewal period in determining the lease term.

An entity shall determine the lease term as the noncancellable period of the lease, together with all of the following:

1. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
2. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
3. Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.

Unlike a renewal option controlled by the lessor, periods covered by a renewal option controlled or effectively controlled by a third party may or may not be included in the lease term. Judgment must be applied to determine whether an option controlled or effectively controlled by a third party should be reflected in the lease term.

The assessment of whether it is reasonably certain that a lessee will exercise an option should be based on the facts and circumstances at lease commencement. The assessment should not be based solely on the lessee’s intentions, past practices, or estimates. It should focus on the factors that create an economic incentive for the lessee, including contract-, asset-, entity-, or market-based factors.

We believe that a lease that is cancellable only upon the occurrence of a remote contingency should be considered noncancellable for lease classification purposes.

If significant enough, a penalty for cancellation may result in a conclusion that continuation of the lease appears, at lease commencement, to be reasonably certain. If so, it should be considered noncancellable for any periods in which the penalty exists.

Question LG 3-5
How should a lessee consider its past practices in assessing whether it is reasonably certain to exercise an option to renew a lease or to purchase an underlying asset?

A lessee should not rely solely on past practice, but should consider the economics underlying its negotiated arrangement. The FASB acknowledged that optional terms may not meet the conceptual definition of a liability, and therefore, the measurement of a lease liability should include options only when the lessee has economically little choice but to exercise the option. However, a lessee’s past practices (e.g., its history of retaining assets for a particular length of time before replacing them) may be in response to factors that would commercially compel the lessee to renew the lease or to exercise a purchase option.

To determine whether a renewal option is reasonably certain of exercise, a lessee and lessor should compare the renewal rents with the expected fair market rents for equivalent property under similar terms and conditions. In general, a renewal option with renewal rents that are equal to or greater than the rents in the initial lease term is not considered to be reasonably certain of exercise; however, this presumption could be overcome if the economic penalties the lessee would suffer by not exercising the renewal option are significant. Any step-down in rents in a renewal period should give rise to a presumption (which can be overcome) that the renewal option is reasonably certain of exercise by the lessee. See LG 3.4 for factors to consider when determining whether renewal, termination, or purchase options are reasonably certain of exercise.

Question LG 3-6
How should a lessee and lessor determine the lease term in an arrangement that has no explicit end date?

A lessee and lessor should evaluate the enforceable rights and obligations in the contract. Any period that may not be cancelled by the lessee should be included. Additionally, any provisions that allow the lessee to extend the lease (i.e., renewal options) should be evaluated to determine whether the lessee is reasonably certain to exercise them. For example, a lease agreement may provide a lessee with the right to use an underlying asset on a daily basis (no stated end date) that the lessee may return at any point subsequent to the first day of use. The noncancellable period of this type of lease would be a single day and each subsequent day would be considered a daily renewal option that should be included in the lease term if determined to be reasonably certain of exercise by the lessee after considering all relevant contract-, asset-, entity-, and market-based factors.

Question LG 3-7
How should a lessee and lessor determine the lease term in an arrangement that can be canceled by either party?

A lessee and lessor should first evaluate whether both parties have the unilateral right to terminate the arrangement (i.e., symmetrical termination rights). If termination rights are symmetrical, the lessee and lessor should determine if terminating the lease would result in either party incurring more than an insignificant penalty, as defined in ASC 842-10-20. If the termination rights are symmetrical with no more than an insignificant penalty, the lease term is limited to the period up to the time those symmetrical rights are exercisable. If termination rights are not symmetrical or either party would incur more than an insignificant economic penalty, the lessee and lessor should follow the framework discussed above.

When evaluating whether the lessee or lessor would incur more than an insignificant economic penalty, they should consider not only cash payments required to be made upon exercise of the termination options, but also other penalties, such as the cost of abandoning leasehold improvements or the disruption caused by relocating employees (see LG 3.4 for other examples of termination penalties). We believe arrangements such as these will be most prevalent in related party agreements. See LG 3.2 for other related party leasing considerations.

Question LG 3-8
Would a lease with a nonconsecutive term totaling 365 days or less be considered a short-term lease if the overall agreement spans a period more than 12 months?

Yes. We believe the determination of short-term, as defined in ASC 842-10-20, should be evaluated on the basis of aggregate nonconsecutive periods. See LG 2.2.1 for information on the short-term lease measurement and recognition exemption.

Question LG 3-9
Is a lease with a fiscal funding clause (a clause included in some leases with federal, state, and local government that gives the lessee the right to cancel if funds are not appropriated in future years) considered noncancellable?

Generally, yes. A fiscal funding clause should be evaluated to determine whether it is more than remote that a lessee will exercise the clause. If it is determined that a lessee’s exercise of a fiscal funding clause is more than remote, only the periods for which exercise is remote should be included in the lease term. In evaluating these provisions, the factors to be considered may include (1) a lessor’s experience relative to other similar leases with the same lessee and/or with similar lessees and governmental agencies, (2) technological obsolescence, and (3) whether the leased asset is essential to continued normal operation of the governmental unit.

Example LG 3-1, Example LG 3-2, Example LG 3-3, and Example LG 3-4 illustrate the effect of renewal options on the lease term.

Lessee Corp enters into a 15-year ground lease agreement. The lease grants Lessee Corp an option to renew the lease for an additional 15 years. The ground rents adjust to current market rates for equivalent unimproved land upon exercise of the renewal option.

Lessee Corp plans to construct a building on the leased land. The cost of the building is significant and its estimated life is 30 years.

The lease term is 30 years. The loss of the building after year 15 as a result of non-renewal of the ground lease provides Lessee Corp a significant incentive to renew the ground lease for another 15 years.

Lessee Corp enters into an agreement to lease an office building for 10 years. The lease grants Lessee Corp the option to renew the lease for an additional 10 years. The rental costs adjust to current market rents for equivalent office space upon exercise of the renewal option.

Since the rents at the beginning of the renewal period will adjust to market rents, the renewal option does not create an economic incentive for Lessee Corp to exercise its option. Therefore, assuming the asset is neither unique nor specialized and no other economic incentives exist, Lessee Corp will likely conclude, at the lease commencement date, that the option is not reasonably certain of exercise. Accordingly, the lease term would be 10 years.

Lessee Corp leases an asset for a 10-year noncancellable period with two 5-year renewal options (the “head lease”) from Lessor Corp. Lessee Corp subleases the leased asset to Sublessee also for a noncancellable period of 10 years with two 5-year renewal options. Lessee Corp (as sublessor) determines Sublessee is not reasonably certain to exercise its options to extend the sublease. Lessee Corp also determines it is not reasonably certain that it will exercise any renewal options in the head lease.

How should Lessee Corp (as sublessor) determine the term of the head lease, considering the renewal options held by Sublessee?

Including optional renewal periods could impact both classification and measurement of Lessee Corp’s lease of the asset. The guidance in ASC 842-10-30-1 (see LG 3.3.3.1 above) states that the lease term includes “periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.”

One might infer that this guidance requires the lessee to include all optional periods it must exercise due to circumstances outside the lessee’s control (e.g., a renewal right over the asset granted by the Lessee to Sublessee). However, Lessee Corp is not required to include the renewal periods in the lease term merely because Sublessee holds renewal rights. Instead, Lessee Corp must assess whether non-renewal by Sublessee imposes an economic penalty sufficient to provide a significant economic incentive for Sublessee to exercise its renewal options. If so, the optional renewal periods would be included in lease term by Lessee Corp in evaluating its lease and sublease. If not, Lessee Corp would classify and measure its lease based on the noncancellable lease term.

In this example, the term of the head lease would be 10 years because (1) Lessor Corp cannot control whether Lessee Corp will exercise the extension option and (2) Lessee Corp concluded it is not reasonably certain that it will exercise any renewal options in the head lease.

Subsequent to lease commencement, Lessee Corp would follow reassessment guidance for lessors to evaluate changes occurring during the sublease term (see LG 5.7). In accordance with lessor guidance on reassessment, Lessee Corp (as sublessor) would not reassess whether Sublessee is reasonably certain to renew the sublease until Sublessee actually exercises a renewal option not already included in the lease term. Until then, Lessee Corp would also not reassess the term of the head lease for the actions of Sublessee (e.g., if Sublessee began installing leasehold improvements, indicating it is likely to exercise a renewal option) as those actions are outside of Lessee Corp’s control. Lessee Corp would follow reassessment guidance applicable to lessees to evaluate changes, including those resulting from triggering events that are within its own control occurring during the head lease term (see LG 5.3.1).

Lessee Corp leases an asset for a 10-year noncancellable period with two 5-year renewal options (the “head lease”) from Lessor Corp. Lessee Corp subleases the leased asset to Sublessee also for a noncancellable period of 10 years with two 5-year renewal options. At lease commencement, Lessee Corp (as sublessor) determines Sublessee is reasonably certain to exercise its options to extend the sublease.

The term of the head lease would be 20 years because Lessee Corp (as sublessor) concluded Sublessee is reasonably certain to exercise its options to extend the sublease. Lessee Corp’s obligation to supply the asset as sublessor results in Lessee Corp similarly concluding the renewal options in the head lease are reasonably certain of exercise.

We believe the same conclusion would be reached if the asset were specialized and, instead of subleasing the asset, Lessee Corp intended to use the asset to fulfill a revenue contract with a third party. That is, Lessee Corp must evaluate whether or not it is reasonably certain that it will use the asset to fulfill the revenue contract during the renewal periods.

Example LG 3-5 illustrates how to determine a lease term for lease portfolios where a lessee can terminate a percentage of the individual leases early.

EXAMPLE LG 3-5
Lease term –Lease portfolios where a lessee can terminate a percentage of the individual leases early

Lessee Corp. leases a portfolio of 100 automobiles from Lessor Corp. Each automobile can be used and operated independent of the other automobiles. Therefore, the arrangement is considered leases of multiple assets. The lease term is three years; however, Lessee Corp has the option to return 40 of the automobiles after 2 years. Lessee Corp. believes that it is reasonably certain that it will return 40 automobiles after 2 years.

The automobiles are similar and there is no higher likelihood that any individual automobile will be returned early. In other words, it is 60% likely that each automobile will be kept for the full lease term and conversely it is 40% likely that each automobile will be returned early.

Lessee Co. should use a three- year lease term for 60 of the automobiles and a two-year lease term for 40 of the automobiles. Lessor Corp. should use the same lease terms.

3.3.3.2 Determining the estimated economic life

Definition from ASC 842 Glossary

Economic Life: Either the period over which an asset is expected to be economically usable by one or more users or the number of production or similar units expected to be obtained from an asset by one or more users.

Determining the estimated economic life of an underlying asset may be similar to establishing the depreciable life of an asset. Depreciable lives may therefore provide a starting point to estimate economic lives for comparable assets. Whether an asset is owned or rented should not affect the length of its economic life.

Determining the estimated economic life of a new asset may be easier than determining the estimated economic life of equipment that has previously been owned or leased. A lessor or lessee should consider the remaining life of the underlying asset at lease commencement.

Lessee Corp is in the business of manufacturing electrical devices for sale in retail hardware stores. Lessee Corp normally purchases equipment used in its manufacturing process from a third-party original equipment manufacturer (OEM) and assigns a 15-year useful life to the manufacturing equipment. Similar equipment must be replaced after 15 to 20 years of use (assuming normal repairs and maintenance during the usage period), after which it is typically scrapped.

In an effort to manage cash flows, Lessee Corp enters into a 10-year arrangement with the OEM to lease a new piece of manufacturing equipment. The new equipment is similar in nature to the equipment Lessee Corp normally purchases; if Lessee Corp were purchasing the equipment outright, it would assign a 15-year useful life for depreciation purposes.

Since the manufacturing equipment needs to be replaced at some point between 15 and 20 years, the estimated economic life should fall within that range. The midpoint of the range (i.e., 17.5 years) may be a reasonable estimate of the equipment’s economic life assuming a more precise method of estimating the underlying asset’s economic life does not exist.

Lessee Corp enters into a 10-year lease with Lessor Corp for the use of a warehouse. The warehouse is 40 years old at lease commencement. Lessee Corp has purchased other warehouses and typically depreciates them over 40 years.

If Lessee Corp simply looks to the age of the warehouse, it may conclude that the building has no further economic life. However, this is not a reasonable assumption at lease commencement given Lessee Corp’s intent to lease the building for 10 years.

The remaining economic life of the building should be estimated based on its condition at lease commencement and Lessee Corp’s estimate of how long the building will be usable in the future assuming normal repairs and maintenance. The assessment should be based on the underlying asset, not the lease term. Lessee Corp may conclude that the building has a future economic life in excess of the 10-year lease term depending on the building’s condition.

When classifying a lease, a lessor similarly should consider the remaining economic life of the underlying asset considering its condition, even if that life exceeds the useful life over which it depreciates the asset.

3.3.3.3 Economic life involving multiple assets

As discussed in ASC 842-10-25-5, a reporting entity should determine which asset represents the predominant asset when a lease component contains multiple underlying assets. Only the remaining estimated economic life of the predominant asset should be considered when classifying the lease component.

Example 13 in ASC 842-10-55-146 through ASC 842-10-55-149 illustrates the application of this guidance to a lease of a turbine plant. The leased turbine plant consists of the turbine, the building that houses the turbine, and the land under the building. The example concludes that these assets collectively represent a single lease component. Considering the lessee entered into the lease to obtain the power-generation capabilities of the turbine, and the land and building would have little to no use or value to the lessee without the turbine, the turbine represents the predominant asset in the lease component. Accordingly, the remaining economic life of the turbine should be used when evaluating the classification of the lease component.

3.3.4 Lease payment tests

This criterion (commonly referred to as the “lease payments criterion”) is met if the present value of the sum of lease payments and any residual value guaranteed by the lessee that has not already been included in lease payments in accordance with ASC 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset. Although the FASB did not include bright lines in ASC 842, it has indicated that one approach to applying this indicator is to consider payments equal to or greater than 90% of the underlying asset’s fair value.

ASC 842-10-30-5 lists the six types of lease payments to be included in the measurement of aggregate lease payments used for lease classification purposes.

1. Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31).
2. Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date.
3. The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option (assessed considering the factors in paragraph 842-10-55-26).
4. Payments for penalties for terminating the lease if the lease term (as determined in accordance with paragraph 842-10-30-1) reflects the lessee exercising an option to terminate the lease.
5. Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset for purposes of applying paragraph 842-10-25-2(d).
6. For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55-36).

If a lease includes nonlease components, their values and associated payments should be separated and excluded for purposes of lease classification, unless a lessee makes an accounting policy election not to separate nonlease components for the particular asset class. See LG 2.4 for information on multiple element arrangements and the allocation of consideration to lease and nonlease components.

Question LG 3-10
Are the costs associated with removing leasehold improvements installed by the lessee (i.e., a lessee’s obligation to return an underlying asset to its original condition) considered lease payments?

No. The costs associated with a lessee’s obligation to return an underlying asset to its original condition generally would not meet the definition of a lease payment (defined in ASC 842-10-30-5), and should not be included when assessing lease classification or in the measurement of the lessee’s lease liability. Since the costs are associated with removing the lessee’s owned assets, these costs should be accounted for using the guidance in ASC 410, Asset Retirement and Environmental Obligations.

Question LG 3-11
Are the costs a lessee incurs to dismantle and remove the lessor’s underlying asset at the end of the lease term considered lease payments?

These payments are incurred by the lessee to remove the lessor’s assets and consequently they would be subject to the guidance in ASC 842 (not ASC 410). However, these costs meet the definition of variable lease payments under ASC 842 because the ultimate amount payable will vary based on changes in factors after lease commencement. Because the payments are not based on an index or rate, they should not be included as a lease payment when assessing classification or in the measurement of the lessee’s lease liability.

Question LG 3-12
Should lease payments include nonmonetary consideration (e.g., common stock of a lessee)?

Generally, yes. We believe noncash consideration should be included in lease payments, measured at fair value on the lease commencement date. However, there are certain forms of noncash consideration that are explicitly excluded from lease payments, such as a lessee’s guarantee of a lessor’s debt.

It depends. Provisions in a lease agreement commonly require a lessee to pay a deposit to a lessor at or before the lease commencement date to financially protect the lessor in the event the lessee damages or does not properly maintain the underlying asset. If the asset is not damaged and is properly maintained, the lessor is required to reimburse the lessee for the full amount of the deposit at the end of the lease.

If a deposit paid by a lessee to a lessor is refundable, we do not believe the deposit is a lease payment. Rather, the payment should be accounted for as a deposit asset and liability by a lessee and lessor, respectively. Deposits should be evaluated to determine whether it is probable all or a portion of the deposit will be returned to the lessee at or before the end of the lease term. When an amount on deposit is less than probable of being returned to the lessee, it should be recognized in the same manner as a variable lease payment (i.e., a period cost).

If a deposit paid by a lessee to a lessor is nonrefundable, we believe the deposit is a lease payment. For example, if a lessee is required to pay a lessor a deposit at or before the lease commencement date to demonstrate its commitment to lease the underlying asset, the deposit should be accounted for as a fixed lease payment.

Question LG 3-14
Should a lessor account for sales tax and other similar taxes collected from a lessee as contract consideration?

It depends. As an accounting policy election, a lessor may account for sales tax and other similar taxes collected from a lessee as lessee costs. If this policy is elected, a lessor would exclude these costs from contract consideration and variable consideration and present revenue net of these costs. If elected, adequate disclosure of the policy election is required. This policy election cannot be applied to a lessor’s gross receipts taxes.

Question LG 3-15
How should a lessor account for costs that are explicitly required to be paid by a lessee on the lessors’ behalf?

It depends. A lessor should exclude from variable payments all lessor costs that are explicitly required to be paid directly by a lessee on behalf of the lessor to a third party. Examples include property taxes and insurance. A lessor would report revenue net of these amounts. Costs that are not part of contract consideration that are paid by a lessor to a third party and reimbursed by the lessee are considered lessor costs and would be accounted for as variable payments by the lessee. The lessor would therefore report these amounts gross on the income statement. ASC 842-10-15-40A only relate to costs associated with the lease, and not lease payments themselves.

Question LG 3-16
Are payments related to non-performance-related default covenants considered lease payments for lease classification purposes?

No, any payments that must be made as a result of non-performance are not considered when assessing lease classification. These payments are considered variable lease payments.

3.3.4.1 Fixed lease payments

Fixed lease payments are payments required under the lease. They can be either a fixed amount paid at various intervals in a lease (e.g., a five-year equipment lease with annual lease payments of $2,000) or they can be payments that change over time at known amounts (e.g., lease payments of $2,000 per month at lease commencement that increase annually by $250 per month).

The exercise price of a purchase option should be included in the calculation of lease payments for purposes of lease classification and measurement when exercise is reasonably certain. See LG 3.4 for information on the application of the reasonably certain threshold.

ASC 842-10-30-5 requires lease incentives to be recorded as a reduction of fixed payments when determining lease payments. See LG 3.3.4.2 for information on lease incentives.

Lessee Corp and Lessor Corp enter into a 10-year lease of an office building for fixed annual lease payments of $100,000. Per the terms of the lease agreement, annual fixed lease payments to Lessor Corp comprise $85,000 for rent and $15,000 for real estate taxes.

The fixed lease payments are $100,000. Although real estate taxes are explicitly stated in the lease contract, they do not represent a separate nonlease component as they do not provide a separate good or service. The right to use the office building is the only component. The annual lease payments of $100,000 represent payments related to that single lease component.

See Example LG 3-9 for information on variable payments for real estate taxes. See LG 2.4 for additional information on identifying lease and nonlease components in a contract.

Payments made by lessees for improvements to the underlying asset (e.g., upgrades to lighting, flooring, pantries) should be recorded as prepaid rent and included in fixed lease payments if the payment relates to an asset of the lessor. Determining whether payments made by a lessee for improvements to the underlying asset should be accounted for as lease payments to a lessor or as leasehold improvements of the lessee requires judgment. There is diversity in practice and there are a number of models in use to make the determination. While other models may be acceptable, we believe the following model closely follows the economics.

Generally, if a lease does not specifically require a lessee to make an improvement, the improvement should be considered an asset of the lessee. Payments for lessee assets should be excluded from lease payments when evaluating lease classification and measuring the right-of-use asset and lease liability. However, if the lease requires the lessee to make an improvement, the uniqueness of the improvement to the lessee’s intended use should be considered. Improvements that are not specialized and for which it is probable they could be utilized by a subsequent tenant would likely be considered assets of the lessor. Other factors to consider include whether the improvement increases the fair value of the underlying asset from the standpoint of the lessor and the economic life of the improvement relative to the lease term.

If a lessee is required to complete a lessor asset improvement, but the improvement has not been completed as of the lease commencement date, an estimate of the costs to construct the asset, net of any funding to be provided by the lessor, should be included in lease payments for purposes of classification and measurement. Any subsequent difference between the estimated and actual cost of the improvement should be accounted for as variable lease payments. See LG 3.3.4.3.

3.3.4.2 Lease incentives

As discussed in ASC 842-10-55-30, a lease agreement may include incentives to encourage a lessee to sign the lease, such as an up-front cash payment to a lessee, payment of lessee costs (such as moving expenses), or the assumption by a lessor of a lessee’s preexisting lease. When a lessor assumes a lessee’s preexisting lease with a third party, the lessee and lessor should independently estimate any loss associated with the assumption as illustrated in ASC 842-10-55-30(b).

Excerpt from ASC 842-10-55-30(b)

For example, the lessee’s estimate of the lease incentive could be based on a comparison of the new lease with the market rental rate available for similar underlying assets or the market rental rate from the same lessor without the lease assumption. The lessor should estimate any loss on the basis of the total remaining costs reduced by the expected benefits from the sublease of use of the assumed underlying asset.

Like other amounts included in lease payments, lease incentives are included in the calculation of consideration in the contract, which must be allocated when multiple components exist (e.g., lease and nonlease components). However, irrespective of the allocation, lease incentives always reduce the consideration in the contract for a lessee and lessor.

For a lessee, the reduction to fixed lease payments will affect lease classification and the initial measurement of the right-of-use asset and lease liability. For a lessor, the reduction will affect lease classification and the measurement of lease income on a straight-line basis (if classified as an operating lease) or the net investment in the lease (if classified as a sales-type or direct financing lease).

Lessor reimbursement for some (or all) of the costs a lessee incurs to complete leasehold improvements is a common example of a lease incentive. These payments may be calculated as a certain amount per square foot or a fixed amount regardless of the level of improvements undertaken by a lessee.

To determine whether a payment from the lessor to the lessee represents a lease incentive, a reporting entity must determine whether it represents a lessee or a lessor asset. See LG 3.3.4.1 for additional information about making that determination. If an improvement represents a lessee asset, the lessor payment is a lease incentive that should be recorded as a reduction to fixed lease payments. On the other hand, when a lessee pays for an improvement that is a lessor asset, the expenditure is prepaid rent rather than a lease incentive; the reimbursement is a reduction to prepaid rent. If a lessee was not fully reimbursed, the difference between the costs incurred and the reimbursements received would be included in lease payments.

If a lessor agrees to pay a fixed or formula-based amount to the lessee once the lessee provides evidence of the expenditures and the contract does not specify the nature of the improvements to be completed, it is reasonable to conclude that the improvements represent lessee assets. However, if the amount a lessee will receive is based on the actual costs incurred on improvements that are specified in the contract, judgment will be required to determine whether the improvements represent lessee or lessor assets.

When lessor reimbursement for lessee assets (i.e., a lease incentive) occurs subsequent to lease commencement, the lessee and lessor must determine whether the lease incentive is considered fixed or variable. If the incentive is subject to a cap and it is reasonably certain the lessee will use some or all of the amount available for reimbursement by the lessor, we believe the portion of the incentive that is reasonably certain of use should be treated as an in substance fixed lease payment (i.e., reduction to lease payments). A leasehold improvement allowance that is negotiated between a lessee and lessor creates an economic incentive for the lessee to use the full amount of the allowance. Therefore, negotiated lease incentives are generally considered reasonably certain of use because a lessee is economically incentivized to use the entire incentive that it negotiated.

For lessees, at lease commencement, if an allowance for lessee assets represents an in substance fixed lease payment, we believe a lessee should estimate the timing and amount of the payments not yet received and include them in lease payments when classifying the lease and measuring the lease liability, which in turn would get reflected in the right-of-use asset. See LG 3.3.4.3 for further discussion on in substance fixed lease payments.

Similarly, a lessor should estimate the timing and amount of the payments not yet paid when classifying the lease and measuring the net investment in the lease if classified as a sales-type or direct finance lease. If classified as an operating lease, although there is no impact to any amounts recorded at lease commencement, the reduction to lease payments is included in the calculation of lease income that will be recorded on a straight-line basis over the lease term.

If an incentive is determined to be variable at lease commencement, we believe a lessee should account for the lease incentive as variable rent when the contingency is resolved. Therefore, the incentive does not impact lease classification or initial measurement of the lease liability.

Question LG 3-17
How should a lessee account for in substance fixed lease incentives that will be used to construct lessee assets when all other lease payments are entirely variable?

We believe that at lease commencement, the lessee must measure the lease liability and right-of-use asset in accordance with ASC 842-20-30-1. Because the lease payments (other than the incentive) are entirely variable, this would result in the recognition of a receivable rather than a liability. This would also result in a negative right-of-use asset (prior to considering the impact of any prepaid rents or initial direct costs), which would be classified as a liability. The liability would then be amortized on a straight-line basis over the lease term as a reduction to rent expense.